Living with Inflation

The cruel choice between two evils, unemployment and inflation, has become the major economic issue of the day. Democrats and Republicans agree that both evils must be avoided and differ only on the means—with Democrats largely favoring the more drastic remedies. Congress has thrust upon the President authority for direct controls on wages and prices. The Administration has relied on traditional fiscal and monetary measures, including changes in taxes and spending and Federal Reserve control over the supply of money. First it tried to hold down prices by using tight money to restrain demand; now it is trying to create jobs by using budget deficits and easier money to expand demand. But the results, so far, are not encouraging. The traditional measures produced a recession and rising unemployment, but inflation hardly slowed down. Now both the recession and the inflation seem very stubborn.

Nevertheless, inflation and recession are usually alternative afflictions. One of the most dismal and best verified observations of modern economics is that there is ordinarily a trade-off between the rate of inflation and the rate of unemployment. Less of one means more of the other. Hence, full employment (which means an unemployment rate between 3 1/2 and 4 1/2 percent) can, on the average, be sustained only with 4 to 5 percent inflation. Price stability (another Pick-wickian term, meaning annual inflation of no more than 1 to 2 percent) is possible only with more than 5 percent unemployment.

The basic explanation for this trade-off (known to economists as the “Phillips curve”) is that, when business is booming and unemployment is low, labor and management can claim wages and profits which add up to more than 100 percent of the value of output they produce at current prices. Not everyone can be satisfied without a rise in prices. Inflation is a peaceful and anonymous resolution of these inconsistent and conflicting claims. When unemployment and excess productive capacity are high, claims for higher wages and profits are checked by actual or potential competition. But it would take a virtual depression to stabilize prices altogether.

One reason for the inflationary bias of our economy is that strong unions and corporations are insulated against the pressures of competition. But even in the competitive sectors of the economy there are powerful forces which push up prices during good times. The crucial factor is the universal reluctance to accept setbacks in money income. Wage rates for a given job can almost never be cut. Many firms would rather lose short-run profits than lower prices. The economy depends on changes in prices and wages as signals to move labor and other resources from sectors of declining demand to sectors of growing importance. But if prices and wages can never go down, there is only one direction in which they can move in response to changing economic conditions.

Although a slowdown of demand aggravates one disease, unemployment, while ameliorating the other, inflation, it does the first right away and the second with …

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Letters

Life with Inflation September 23, 1971